Some successful traders only trade during the first hour or so of the trading day. The reason is simple. They’ve found that 90% of their profit comes during that time period. Therefore, the extra effort to trade throughout the day isn’t worth it and, even more important, drains energy and puts them at risk of not being sharp the next morning.
No question, the best time to trade is the first hour or two. The moves tend to be large and the signals are often clear. However, the difficulty for many traders is that patterns often develop too quickly to instill confidence. One way to gain confidence is to simplify your analysis. You can do this by looking for variants of three patterns: a trend from the open (first bar or first few bars), a breakout pullback and a failed breakout.
Before we get to examples of these patterns, let’s first review some basics of price action trading. This is a day-trading approach that relies on five-minute charts. The only indicator is a 20-period exponential moving average. The strategy is effective in E-mini S&P 500 futures, stocks, options, forex and, as demonstrated here, 10-year Treasury note futures.
The strategy enters on a stop at one tick beyond the signal bar. For example, if there is a buy setup, a buy stop to go long is placed one tick above the high of the previous bar. For T-note futures, a typical initial risk is six ticks ($93.75 per one-lot). However, if the bars and the average daily range are large, it may be appropriate to risk more or trade fewer contracts; often, the profit target on the scalp portion of the trade also is increased.
At the close of the entry bar, the stop typically is tightened to one tick beyond the entry bar. After taking a scalper’s profit (four to eight ticks) on part of a position, the stop is moved to roughly breakeven on the swing portion of the trade. For most trades, if you pick the correct entry, the market immediately goes your way and does not come back to let other traders come in at a better price.
The previous day’s price action usually influences what happens on the current day, especially in the first hour. If you use 24-hour charts, you likely will not have enough bars on your screen to see what took place the previous day. If you have the ability to set the start time of your charts, then you can pick any time between 5 a.m. and 5:30 a.m. Pacific time; this is when volume picks up (encompassing the 5:20 floor open) and more accurately represents institutions placing their bets. One effective approach is to start your charts at 5 a.m. and end them at 1:15 p.m. Pacific. The floor closes at 2 p.m. Central (noon Pacific) but there usually remains adequate liquidity prior to the electronic open for the next day.
TRADING PRICE ACTION
To get started, look at the last hour or two of the previous day’s action and see if a trendline can be drawn, or if there is a horizontal or sloping trading range. Then, as the current day’s bars form, look to see how they relate to the pattern from the prior day.
In “Range to gap” (right), a previous-day large trading range preceded the current day’s gap down, creating a breakout below the range. One way to view a gap on the open is as a single invisible bar, so a gap down can be considered a bear trend bar. A gap often results in a trend in either direction, but the larger the gap, the more likely the day will continue in that direction.
The first bar of the current day was a bear trend bar (a close below its open), which indicates that the bears owned the bar. At this point, look for evidence that either the day could start to trend up or down from the first bar. Alternatively, there will be a pullback into the gap and then the bear will resume. This is a breakout pullback short setup. Finally, the breakout could fail after a few bars down and then trend up (a failed breakout).
The second bar had a bullish body, but it had an unremarkable range and it closed in the middle, indicating that the bulls were not strong. The third bar (Bar 1) was an inside bar, indicating hesitation or balance between the bulls and bears, and a breakout therefore was likely within a bar or two. The bar closed on its low and this was evidence that the bears were stronger. If you are ever going to trade a trend-from-the-open setup, you must be prepared to enter on one of the first bars of the day.
This setup has a great risk-to-reward ratio. The bar is three ticks tall, so if you entered at one tick below its low and put a stop at one tick above its high, you are initially risking five ticks ($77.625), and you stand to make maybe 20 or more. That means that you have to be right only 25% of the time to break even.
In the case of the current example, given the bear gap and bear bars, the odds that this setup would result in a profitable short likely were much higher. The Bar 1 entry bar opened on its high and closed on its low, which is evidence that the bears were strong. The next bar was a large bear trend bar that broke below the low of the first bar of the day. This presented an opportunity to take some contracts off with eight ticks of profit or hold the entire position for a possible significant move down. If you are right, you are short at five ticks from the high of the day, and the average daily range has been about 20 full ticks.
In bar-counting vernacular, Low 1 is the first time that a bar goes below the low of the prior bar if that prior bar is a pause or pullback bar. Low 2 is the second time in a bear flag that the market tries to go down. High 1 and High 2 are entries in bull trends. Bar 2 was a Low 2 short setup (this is the second attempt to go down after a small pause or pullback, and the Low 1 short occurred three bars earlier), and a small double top. The market could not rally to the breakeven stops on the Bar 1 shorts, and it formed a second Low 2 short and larger double top at Bar 3. The market trended strongly down from there to the small three pushes down (or wedge) at Bar 4. You could exit at that small climax with 35 ticks of profit, take partial profits or continue to hold to see if the bear extended further.
In “Running higher,” the previous day had a protracted bear move into the close. The current day’s open broke above the trendline, but the first three bars were small dojis, which represent small trading ranges. These are usually not reliable signal bars, so it is prudent to wait for more price action to unfold.
The third bar of the day was a High 1, but the dojis make waiting for more price action the best choice. Bar 1 was a High 2 long following three consecutive inside bars (an iii pattern), but the day has been in a tight trading range and the pullback has not yet tested the moving average, so it is reasonable to wait some more. The test of the moving average formed a double bottom and was followed by another iii, with the signal bar having an up close and three of the four prior bars had up closes, and the market has been unable to close below the moving average. This double bottom formed a higher low following the breakout above the trendline of yesterday and it could become the low of the day (a breakout pullback long).
A long here risks five ticks to one tick below the small inside bar. You could take half off after eight ticks of profit and hold the remainder with a breakeven stop for a possible bull trend day. Once Bar 3 broke above the wedge, the market was likely to go up for at least a measured move because the bears who shorted the wedge gave up and there was no one left to short. The market closed about 48 ticks higher, earning longs $750 per contract, with an initial risk of under $90.
“Quick opportunity” (above) had a small bear flag into the close of the previous day that broke the bear trendline, so traders were alert to a possible trend reversal up after a higher low or lower low test of the previous day’s bear low.
The current day tried to break out to the upside of the small bear flag on the open, forming a possible trend-from-the-open bull. Bar 1 reversed down following the break above the trend channel line, and was a reasonable short (a wedge) of the expanded bear flag, expecting a test of the bear low from the prior day. The market broke below the bear flag but the breakout failed (a failed breakout, turning the bear flag into a large final flag) and reversed up at Bar 2, which was a large range bar that broke a small trend channel line and was therefore a likely sell climax. It also reversed up from the previous day’s bear low. Although it had a bear body, it closed near its high, so the bulls were strong.
The market appeared to successfully test the bear low and showed signs of possibly reversing into a bull trend. In such a scenario, traders should buy above the high of Bar 2 and scalp out part at about eight ticks, or after the bear reversal bar above the high of the current day’s open. A breakeven stop would have been hit on the pullback, but traders would be looking to buy the higher low. After there is a trendline break and then a reversal from a lower low, there is usually a higher low and then at least one more leg up. Traders who bought the Bar 4 higher low and test of the breakout above Bar 2 could take partial profits above the prior Bar 3 high for another eight to 12 or more ticks. The day went largely sideways from that point.
As a price action trader, it’s important to pay attention to every bar because every bar tells you something about the market. There are far more trading opportunities on the five-minute chart than most people would ever imagine, but if you are willing to watch carefully and think about what is going on, you will understand much of what the chart is telling you.
The importance of concentrating on each bar highlights the advantage of zeroing in on the open. By concentrating on the open you are able to narrow your focus to the period with the best opportunities and most clear cut signals. With nearly 100 five-minute bars in the active trading session, it may be wise to limit your trading activity to the periods that offer the best opportunities. You will often see setups that allow for great risk-reward entries and you will avoid missing signals due to fatigue.
Al Brooks, M.D., is the author of “Reading Price Charts Bar by Bar: The Technical Analysis of Price Action for the Serious Trader” (Wiley, 2009) and has been posting end-of-day analysis on brookspriceaction.com.